Get below the sales pitch

Always remember a fund company isn't an altruistic enterprise

Your Money

December 25, 2005|By CHRISTINE BENZ | CHRISTINE BENZ,MORNINGSTAR.COM

Like an extended warranty on a new PC or the time-share pitch that's disguised as a "free" vacation, knowledgeable consumers know that some deals that look good on the surface aren't all they're cracked up to be once you read the fine print.

The same holds true in the investing industry, where financial-services firms often make products look like bargains even when they're not.

Bottom line: Never forget that financial-services companies aren't in this business to be altruistic; they're in it to make a profit. Before you bite on an investment because it seems like it's too good a deal to pass up, ask yourself what the firm offering it stands to gain. (It's often more than you might think.)

1. Hoarding company stock - even when you've bought it at a discount.

Many publicly traded companies give their employees the opportunity to purchase their stock at a discount to the current share price. That might seem like a good deal - more so if your employer's stock price is soaring. But loading up on your company's stock can be dangerous, particularly if you're hoarding your employer's shares at the expense of building a welldiversified portfolio.

Remember: You already have a lot tied up in your company's financial health and your industry via your job, so it's a mistake to compound that effect by socking a disproportionate share of your portfolio into your employer's stock. To be on the safe side, limit employer stock to no more than 5 percent of your overall portfolio.

2. Buying a cheap fund, then paying commissions on small purchases.

Exchange-traded funds have recently taken off in the marketplace, in part because their expenses can be lower than mutual funds that invest in the same basket of securities. Before you venture whole-hog into ETFs, however, take a step back and think about your investment style. If you plan to make a lump-sum investment and let it ride, the ETF may well be the best bet for you.

However, that's not so if you trade frequently or make small purchases at regular intervals (and dollar-cost-averaging is a great way to invest, by the way). That's because you'll pay a commission to buy and sell ETFs, and those charges could quickly erode any cost savings versus plain-vanilla mutual funds. Ditto for paying a transaction fee to buy a fund in a mutual fund supermarket or buying a front-load fund, even if its expenses are low.

By the same token, many investors always stick with the no-transaction-fee lineup (those investments for which you don't pay a commission to buy and sell) in their mutual fund supermarkets, even if it means opting for subpar offerings or those with high continuous expenses. If you plan to buy a fund and let it ride (you're rolling over a 401(k) into an IRA, for example), you may well be better off paying the transaction fee if the trade-off is that you'll be able to get into a better, cheaper fund.

4. Opting for target-maturity funds from a third-rate fund company.

I'm a big fan of target-maturity funds, which "mature" as you get closer to your goal, usually retirement. (Surprise, surprise: Fund companies seem to like the idea of putting you in a fund that you'll hang on to for the next 20 to 30 years.)

These funds can be a great deal for investors, as they help you arrive at an appropriate asset mix given your time horizon and may not charge you an additional fee for the "advice." Not all target-maturity funds add up to a great deal, however. Some fund shops charge additional management fees to pull the whole package together (above and beyond what the individual funds charge), and the underlying funds may themselves be expensive.

In addition, most fund shops simply aren't good enough at running money in all three major asset classes - domestic stocks, bonds and international - to serve as your one-stop destination. I'm comfortable recommending the target-maturity funds from Fidelity, Vanguard, T. Rowe Price and American Century, but I am less enthusiastic about the other target-maturity vehicles in the marketplace.

5. Settling for expensive index funds.

As with target-maturity funds, here's an example of good concept/lousy execution. Index funds can be a terrific way to obtain broad market exposure at a very low cost.

Yes, even expensive index funds probably look cheap alongside most actively managed vehicles, and they may be your best bet if the other options in your company retirement plan are truly subpar. But recognize that with an index fund, you're making the assumption that you're going to under perform the market (by the amount of your costs); the only thing you can control is by how much. Look for the cheapest index fund you can find.

Christine Benz writes for Morningstar.com and does not own shares in any of the companies mentioned above.